Research Magazine 2015

John L. Abernathy, Brooke Beyer, Andrew Gross, and Eric T. Rapley

Income Statement Reporting Discretion Allowed by FIN 48: Interest and Penalty Expense Classification Coles Working Paper Series, FALL14-01, October 2014

Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48) provides guidance on accounting for uncertain tax positions including the accrual of interest and penalty expense on unrecognized tax benefits (UTB). However, FIN 48 allows managers discretion over the classification of UTB interest and penalty expenses on the income statement. We use this unique setting to investigate whether tax avoidance behavior influences managers’ financial reporting decisions and determine whether these decisions have implications for financial reporting transparency. Managers of firms engaged in more tax avoidance may have an incentive to include UTB interest and penalties in tax expense, which can inflate the reported tax expense on the income statement, to better obfuscate their tax avoidance behavior and avoid increased scrutiny and reputational costs. We find firms with low effective tax rates (ETR) and firms engaged in tax disputes are more likely to include UTB interest and penalties as components of tax expense. We also find the inclusion of all UTB interest and penalties in tax expense is associated with less accurate analyst forecasts. This suggests that income statement classification of interest and penalties have an effect on financial statement transparency.

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